What is going on here? By all accounts, the 5 1/2-year-old economic expansion should be fizzling out. Already ancient by historical standards, the upswing appeared to have suffered a devastating blow when the stock market crashed last October. But, defying expectations, the economy is still running and even blowing off enough steam to inspire fears that it may actually be overheating. Forget about a recession, many economists counsel, and start worrying about inflation. Once a faint and far-off danger, rising prices may now pose the gravest threat to economic stability.
Responding to that threat is the job, as always, of Chairman Alan Greenspan and the other governors of the Federal Reserve. As the person in control of the U.S. money supply, Greenspan has the primary responsibility for preventing a price explosion. Last week he seemed to be moving decisively to cool things down by letting interest rates rise. The so-called federal funds rate, the interest charged on overnight loans among banks and the best day-to-day indicator of Federal Reserve policy, inched up from just under 7% to about 7.25%. In response, major banks hiked the prime lending rate they charge commercial customers from 8.5% to 9%.
That made investors recall the last time the banks raised their prime: Oct. 7, only twelve days before the crash. This time the reaction on Wall Street to rising interest rates was not nearly so violent. On the day the prime went up, the Dow Jones industrial average dropped 37.8 points, to 1965.85, but then it recovered a bit to finish the week at 1990.55.
The crucial question is how high the Fed will let interest rates go in its effort to slow the economy and ward off inflation. The answer will have immense political as well as economic ramifications. In this presidential election year, the Republicans will jawbone the Fed, which now consists solely of Reagan appointees, to keep a lid on interest rates, while the Democrats will watch intently for any signs of partisan policymaking.
The clearest indication that the economy might be expanding too quickly came two weeks ago, when the Labor Department reported that the unemployment rate fell from 5.6% in March to 5.4% in April, its lowest level in 14 years. While the drop was good news to anyone looking for work, many economists were alarmed because they believe that unemployment can fall only so far before inflation starts to accelerate. While no one knows precisely where this "trigger point" is, many economists think it is now no lower than 5.5%. During the Carter Administration, inflation accelerated sharply when unemployment dipped below 6%.
Current statistics provide disturbing evidence that the inflation trigger has been pulled again. In March consumer prices shot up at an annual rate of 6.4%, in contrast to a 4.4% rate for last year. Over the past two months, producer prices rose at about a 6% pace, nearly triple their 2.2% increase in 1987.